Pension System Modernization to Promote Reliability and Efficiency

Pension savings, which can only be claimed after 45 years of work, are long-term investments that can, therefore, be used for large infrastructure projects, such as the construction of railroads, highways, pipelines and ports.

The world has accumulated considerable experience in the use of pension savings. There are three main types of pension schemes. Individual-funded, when pension fees paid by the employees or employers are accumulated in individual accounts; the solidarity, or unfunded, scheme, organised on the principle of intergenerational solidarity, when pension contributions are not saved, but paid to pensioners; and the distribution system, when pensions are paid from general tax revenues. This type of pension is usually used for payments to vulnerable citizens such as the disabled and paying survivors’ benefits.

States seek to provide reliable pension savings schemes that are also efficient. These funds must work and their idle accumulation would be wasteful. Creating reliable, guaranteed protection for pension savings is a basic principle when they are used as investment funds. It is an axiom. As a rule, these savings are protected by the state.

Governments can either trust the private business sector to manage pension funds, or they can do it themselves.

Government-directed investment of pension funds is carried out by many leading countries. This practice is satisfactory for the public. At low inflation and in the conditions of a stable economy, the government’s priority is reliability of returns on its investments rather than higher returns from investing in business. Developed nations have had bitter experiences when eminent companies, whose shares had been purchased by pension savings funds, collapsed overnight, burying the hopes and future incomes of pensioners. That is why the principle guiding the investing of pension funds remains, “reliability above profitability.”

Many countries such as Chile skillfully use the investment potential of pension funds.

In the initial period of free market reforms, a romantic mood prevailed in economic policies in our country. We thought that, being active pioneers in the introduction of free market policies, we would achieve substantial results on the use of advanced methods of retirement savings. We created private funds that accumulated the bulk of pension funds in the country: by Jan. 1, 2013, the number of contributors (recipients) of pension funds in the country increased to 8,422,512 and their accumulations grew to 3,183.2 billion tenge ($21 billion). Annual payments to pensioners reached 323 billion tenge ($2.14 billion). Currently, there are 11 pension funds in the country. Four of them hold 75 percent of total retirement savings. They are: the People’s Bank of Kazakhstan with 33.3 percent, SAPF with 19.6 percent, Ular Umit with 12.6 percent and Grantum with 9.6 percent.

The main problems

The role of the pension sector in the economy is growing. The ratio of retirement savings’ ratio to GDP grew to 10.1 percent on Jan. 1, 2013 and the ratio of pension contributions rose to 7.8 percent. The structure of total assets and capital pension funds totaled 107.3 billion tenge ($710 million).

However, during the 20 years that pension funds have existed in Kazakhstan, major problems in their operations have come to light.

Some successful companies, especially working in raw materials sector, got their shares listed abroad, where they could attract relatively cheap money and subsequently painlessly repay it. Other successful companies do not intend to place shares on the domestic stock exchange. As a result, the domestic stock market has shrunk.

The government tried to limit the scope of application of pension savings, to protect them from excessive risks. But this meant the investors of retirement savings were left without high income returns. More than half of all pension savings are invested in government securities (50.5 percent), mainly in securities issued by the Finance Ministry (49.1 percent of investments in government securities). Then come investments in state corporations (25.9 percent), mainly bonds (20.5 percent). This figure is now falling. The share of other financial instruments is 23.6 percent.

The current situation can be interpreted in two ways. Deposits are only growing in two directions – in government securities and in second tier banks. This confirms that the pension funds are still following a cautious, reliable investment policy. On the other hand, support of the private sector is also attracting major investment from the pension funds. The state has no monopoly on the use of pension funds. The non-state sector received 812.1 billion tenge ($5.31 billion) this year, 87.9 billion tenge ($580 million) more than in 2012.

High inflation is one of the characteristics of an emerging market. Logically and historically, it should be relatively low in our country, but it is artificially maintained at a high level because of deformation of market relations, lack of business competition and excessive speculation in the trade and financial sectors.

Inflation destroys at the grassroots the return of investments of pension funds. Inflation is higher than the yield. Thus, from November 2009 to November 2010 the nominal income ratio was 16.95 percent at the inflation rate in this period of 26.82 percent. From November 2009 to November 2010 the figures respectively were 4.17 percent with an inflation rate of 7.70 percent. A similar picture emerged in the current 2012-2013 period.

Analysis shows that in the short term, the cumulative inflation rate significantly exceeds an average ratio of pension funds’ nominal income on both moderate and conservative investment portfolios.

Under such circumstances, there is no sense to motivate the existence of private pension funds. The limited market forces the individual pension funds to participate in high-risk investments in order to acquire shares of not reliable and sometimes dubious companies and banks. As a result, a number of pension funds suffered significant damage. As of Jan. 1, 2013, the loss of pension funds for the default of issuers on securities amounted to 16.9 billion tenge ($110 million). The market, in fact, was not ready for the adoption and use of pension savings. Inflation destroyed the quality of long term, or “long” money, which is the main advantage of retirement savings.

According to the National Bank, the cumulative return in the period of 1998-2012 on the moderate investment portfolio was 366.15 percent, on the conservative portfolio – 356.07 percent, and the accumulated value of inflation reached 236.31 percent.

The weak link

The weakest point is the activity of pension funds. The effectiveness of their work is seen in the data for 2010, when seven funds made profits, and six funds incurred combined losses of 2.8 billion tenge (less than $20 million). The following data also show a significant decline in quality of indicators: in 2005-2007, the annual growth of retirement savings averaged from 30 percent to 40 percent, and pure investment income rose to 65 percent; in 2010, these indicators only accounted for 21 percent and 16 percent.

States of mind are important. Some pension fund managers like to live in the grand style. Initially the pension funds had a 0.5 percent commission for using pension assets, and management companies had a 15 percent commission.

Previously, when savings’ rate was low, this remuneration was an incentive. But now, when these assets exceed 3.3 trillion tenge ($21 billion), each percent of interest has grown considerably. Also, the value of the commission is not attached to the performance and is increasingly dependent on the value of pension savings. This negative situation where the material welfare of pension funds’ workers depends on the amount of deductions, only benefits all employees of the system, not the investors.

Unfortunately, this anachronism, when the funds lost profitability, and the incomes of their employees grew, was discovered very late. The money of retirees, present and future, to say mildly, was used wrongly: expensive offices, offroad vehicles, high wages, and holidays in prestigious resorts – all that was afforded on the money of pensioners. Excessive and avoidable costs have become a norm. Thus, every year 600 million tenge ($3.98 million) is spent on notification of investors about the state of individual retirement accounts. Expenditures on maintenance of the automated information system for technical support, renewal of licenses, and so on, reached 500 million tenge ($3.31 million). These and other costs are covered at the account of pension assets, through the establishment of high rates of fees for management and investment activities.

Moreover, there were elements of criminal acts and creation of theft schemes. Thus, according to the National Bank, some of the funds acquired securities of affiliated companies that fell into default and the shareholders of the funds were associated with these artificial defaulted, loss-making companies.

When the mechanism does not work

According to the National Bank, in the period from 2004-2012, two national pension funds (NPFs) were eliminated: the NP Valut-Transit Fund and Korgau. During the same period, the National Bank ordered the reorganisation of five NPFs: Industrial Kazakhstan which had to merge with SAPF; Amanat Kazakhstan which merged with Eurasian NPF, later renamed to NSP Astana; BTA Kazakhstan merged with Ular Umit and KNPF Philip Morris Kazakhstan and NONPF Kurmet merged with other pension funds.

The key point is that the market mechanism of pension contributions does not work. Ultimately, the state suffers the cost of defects in this segment of the financial market. Even now, as the yield of the funds is guaranteed by the state, over 8 billion tenge ($53 million) was spent to cover the losses. But the main problem, due to the low yields and losses in some pension funds, is the risk that, starting from 2032, the budget for compensation of losses and current payment of guaranteed pensions will use the money of the National Fund. According to estimates, in the next decade about 1.5 million people will retire, annually from 100,000 in 2011 to 200,000 in 2021 with an average annual increase of pensions by 39 percent.

In addition, for this category of investors, who are in the system from 14 to 23 years, the amount of pension payments by 2022 could reach from 500 billion to 600 billion tenge ($3.31 billion to $3.98 billion).

The main contradiction of the pension system is the increasing gap between the growth in the number of contributors who reached retirement age, and average figure of mandatory pension incomes in the country.

According to the estimates of the National Bank, its head Grigory Marchenko believes that taking into account the growth of pension payments, the budget by 2042 will deplete the National Fund resources received from the country’s oil revenues.

The weakness of the national pension system lies in the fact that of a work force of 8.5 million, 3.5 million, or 41 percent, regularly deduct pension contributions. Furthermore, of 2.7 million of the self-employed, these contributions are made by only 932,000, or 34.5 percent. As a result, the average saving on one pension account made up less than 400,000 tenge at a relative rate of 1.8 million tenge, or 4.5 times less than required.

This category of pensioners requires low tariffs, low prices, and increased social support.

Another problem is the fact that, in 2012, over 17 percent of women, according to Labour and Social Protection Minister Serik Abdenov, did not have the necessary record of work and could not claim to the joint portion of pension payments. According to the minister’s calculations, by 2015, the number of these women will reach 50 percent, and by 2018 – 100 percent.

The way out

What is the solution? Deputy Prime Minister Kairat Kelimbetov has announced the necessity of creating a Single National Pension Fund (SNPF). It is clear that the yield will not essentially change due to the lack of spheres for the retirement savings’ application. But the main thing here is the reliability and guarantee of pension savings’ safety.

It may appear that the government’s measures seem like a step back from market principles in the direction of methods of paternalism and state capitalism. In fact, the essence of the matter is that the state is unsatisfied with the pension funds’ activities and is seeking to optimise their performance. The state itself is using market methods to make its own savings procedures more efficient, fully introducing the tools of public-private partnership.

What measures are being proposed to rescue the pension system? The solution will not come overnight. There are concerns about what is offered in return. The SNPF will be created on the base of the SAPF. The rest of the pension funds are offered three options: liquidation and sale of assets at a decent price; merge into SNPF, or transformation into a managing company. The new pension system, according to President Nursultan Nazarbayev, “will allow more effectively and safely disposing the savings of our citizens.”

First of all in 2013, all individual retirement accounts will be transferred to the SNPF. This transference will be carried out in full. Kelimbetov said this was not nationalization of pension savings, which remain in the property of their owners.

National Bank Chairman Grigory Marchenko said the government must in the long term create reliable protection mechanisms against possible encroachments of the government to close any gap in the budget, since such temptations have been already observed.

Another challengeable proposal is to unify the retirement age. The initiative of Labour and Social Protection Minister Serik Abdenov is quite understandable: there is a threat of a hole in the budget. It is possible to gain some additional years for the system by raising the retirement age for women. However, we cannot say that these are only our own domestic problems. In one form or another they are present in many countries of the world, even in Chile, whose example we followed, and which after 17 years of use of the modernised free market pension system had to retreat from it under the pressure of emerging problems.

Staying within our means

The main weak points of national pension systems are known. Outpacing inflation over the yield, volatility of individual markets, where money is invested, decline in fertility with increasing life expectancy, income disparity in national budgets and the growth in pension payments. Some of them are getting worse.

Indeed, one of the causes of the debt crisis in European countries was the lack of resources to maintain a high level of social standards, including pensions. This is particularly noticeable in the Southern European countries, where labour productivity lags behind the same in Germany, and where pension, for instance, in Spain is almost equal to German ($1,200 and $1,190 respectively). And of course, suggestions of raising the retirement age to 67 years in France, Germany, Italy and to 68 years in Britain causes understandable resentment and fierce popular resistance.

But it’s not easy to recognise the weakening competitiveness of the national economy, falling tax revenues and pensions and a high level of unemployment. Among unpopular measures being taken, we have just seen the decision of the Cypriot Parliament to nationalise pension funds to fight the crisis. Many countries are concerned about the aging of the population while life expectancy is increasing. However, the growth of pension payments puts an increasing burden on the budget of a country.

This contradiction is solved by increasing the retirement age. In Japan, with an average life expectancy of 82.1 years there is a uniform retirement age for men and women at 70 years. In Denmark, Norway and Germany it is 67. In the United States, Canada and Sweden it is 65.

It should be noted that in different countries, the role of non-state pension funds is different. In the United States, Canada, Britain, Australia, they account for more than 40 percent and in the Czech Republic, Poland, Hungary, and Slovakia – for less than 5 perfect.

The world’s pension systems are going through the most difficult stage of their history and long-term forecasts are not optimistic. The pension system of Kazakhstan suffers from the same disease. The desire to minimise the risks to achieve efficiency of the modernised national pension system is a general challenge. There is no perfect solution in the world. We should think how to better and maximally protect old age – there is no alternative to this goal.

We must live within our means. It’s not difficult to distribute all that we have gained, but much more difficult to maintain at a proper level our accumulations. The main guarantee of social welfare was and is the rise of the national economy on the basis of productive diversification, large-scale introduction of innovations and rapid growth in labour productivity.

The author is rector of Turan University and has a PhD in economics.

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